The head vs the brain

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   By Guest Blogger Tatiana Enhorning

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The brain is a powerful organ and no matter how hard we try, it can sometimes overpower our rational mind. Behavioral Finance investor psychology is a fascinating space which acknowledges investors have limits to their self-control and are influenced by their emotions, assumptions and perceptions. These biased and irrational behaviors have real costs. In fact, a study by DALBAR, a financial research firm, has shown that the average do-it-yourself equity investor earned an average annual return of 4.25% in the 20 years between 2000 and 2019, while the S&P 500 added 6.06%.

We often think the world of investing is purely rational and logic-based and with the proper information, we can make the correct decision every time. But try as we might, our past experience and unique brain wiring can often skew vision. Last year you may have noticed your most irrational investing fears and biases rear their ugly heads. Getting to know your brain’s unique wiring and your own personal biases can help you recognize and circumvent these tendencies before they affect investments.

One way of doing this is to get to know what type of investor you are.

Are you an idealist, or a pragmatist?

Firstly, do you fall into more of the “Idealist” or “Pragmatist” category? Idealists are seemingly eternally optimistic about the stock market and tend to seek information that validates this viewpoint. They may overestimate their abilities and underestimate the abilities of others and, therefore, not always do much research before investing. The idealist may read some articles and seek one or two reputable opinions, but really they are susceptible to investing fads. If you’ve bought into the crypto hype over the past few years, then you may fall into this category. Idealists tend to be vulnerable to overconfidence bias, availability bias, self-attribution bias, recency bias and illusion of control bias.

Pragmatists on the other hand do much more in-depth research and know their abilities and limitations. They tend to demonstrate a healthy dose of skepticism about their own investing knowledge and abilities. Pragmatists know that the markets may very well be operating at a more complex level of probabilities which simply may not fall into their field of expertise. Because of this they are also likely to seek out views that are contrary to their initial belief about an investment and then weigh those opinions accordingly.

The difference between framers and integrators

Secondly, are you a “Framer” or an “Integrator”? Investors who are framers tend to view their investments on an individual basis rather than how they fit into the overall portfolio plan. They tend to be very rigid in their approach to analyzing problems and may have different “pots” of money that aren’t really working together: one for long-term savings, one for a down-payment on a new house and one for an upcoming vacation. This is not necessarily a bad thing but framers may very likely have inefficient investment overlap causing concentration risk or drag on performance. They are subject to anchoring bias, which causes them to get stuck on a particular price (such as their own purchase price), or to cling to arbitrary purchase ‘points’, which can lead to biased future calculations. Framers tend to be susceptible to framing bias, conservatism and ambiguity aversion.

The following statements are typical of framers: “My portfolio matched the index this year, but I’m really disappointed with how ABC Company performed. If I didn’t invest in it to begin with, I would have beaten the market by 3 points!”

Whereas the integrator would say, “That ABC stock which performed poorly may end up performing well when the overall market suddenly turns negative.” If you are a fan of this blog and agree with its views on overall portfolio balance and diversification, you likely fall closer to the Integrator profile. Integrators are able to view the broader context. All the investments in all their portfolios are one big integrated system working together in a harmonious ecosystem where every security has a part to play. Integrators tend to understand the correlations between their various financial instruments and structure their portfolio accordingly, with a more flexible approach to market and security price levels.

How reflectors rationalize and realists accept

Lastly, which of the “Reflector” versus “Realist” types best describes you? Reflectors tend to justify and rationalize poor investment decisions instead of taking action to rectify them. They tend to hold on to hope that their fortunes will turn around. They also fear making mistakes and may hold onto securities even when they see they are not a good fit for their overall portfolio. Reflectors often suffer from decision paralysis as they dread the regret of a miscalculation. For example, reflectors may hold onto inherited securities out of sense of loyalty to a deceased relative, even though they are not a good fit for their overall portfolio or market environment. Reflectors may be susceptible to loss aversion bias, endowment bias, regret aversion, status quo bias and hindsight bias.

Realists, on the other hand, do not have trouble coming to terms with the consequences of their investing choices. Once they see they made a mistake, they are quick to admit it and rectify it before the situation gets any worse. Because realists have an easier time making decisions under pressure, they do not experience regret as acutely, and consequently do not dread them ahead of time.

Even smart investors need advice. If you find that you fall into any or all of the first types in each of the three buckets (Idealist, Framer and/or Reflector), a professional financial advisor can be especially advantageous to help you stay on track. If we can notice and get past our most common biases, we can ensure the illogical brain does not foil well-reasoned investment plans.

And if you don’t think you have any biases, then you may have succumbed to superiority bias.

Tatiana Enhorning is a Financial Advisor with Turner Investments. She builds and maintains portfolios for clients across Canada, and has been in the business as an asset manager for more than a decade.